Tanvi Kandlur: The case for and against Japanese equity valuations

Recession risks are heightened if Japan goes ahead with a consumption tax hike

Japanese equities appear to be the most attractive asset class among developed market regions from a valuation perspective. There are various catalysts for the region to re-rate, including robust earnings growth which has almost been as strong as the US and long-term structural growth drivers from a fiscal perspective, but Japanese equities has consistently experienced multiple de-rating. We examine the reasons why and the case for and against the asset class.

Consumers lag corporates in shift from savings culture

Both Japanese corporates and consumers have struggled to break away from the ‘savings’ culture; while this mindset is changing among corporates, this is still very much the phenomenon among consumers. This has led to a struggle to spur growth and fight deflation.

The Bank of Japan has done almost everything it can from massive quantitative easing to yield curve targeting.

The government has also overspent to fight falling growth and deflation; Japan has the highest government debt to GDP ratio globally, leaving the current administration with less tools to work with going forward.

Japan returns excess cash to shareholders

Long-term structural growth drivers exist in the form of improving corporate governance.

Higher levels of foreign investment and a fall in domestic cross ownership has meant that company management have had to increasingly focus on improving profitability, efficiency and maximising shareholder return.

Independence on Japanese company boards are changing; in 2004, 15% of companies had two or more independent directors, while in 2017 that figure has increased to above 95%.

Japanese companies have shifted from retaining high levels of cash to returning excess cash to shareholders through buybacks and dividends which has enhanced returns. Total share buybacks and dividends in Japan still lag that of Europe or the US but is heading in the right direction.

As a result of these structural drivers, Japanese corporate profitability has improved significantly. The return on equity for the TOPIX index reached the levels of MSCI Europe in late 2015. This is an early sign that Japan is shrugging off its low-return past and converging to profitability levels of global peers.

Source: Bloomberg

Cyclical economy drives short selling and active management

Investors however perceive Japanese equities as ‘high-beta’, where it tends to get more traction when global growth is strong but shunned when concerns around growth surface. This has kept long-term investors away and encouraged high frequency traders and hedge funds to engage in short-selling.

Investors who choose to go the passive route will access Japanese equities in a cyclical manner, given that the index has a high proportion in cyclical sectors like autos and industrials and often will not be as exposed to stocks that benefit from the long-term structural drivers.

Japanese equities are poorly covered, especially small and mid-cap stocks, giving active managers a greater opportunity to exploit inefficiencies.

Strong yen and consumption tax threats

Japanese equity markets have historically moved in tandem with the yen. As the currency has weakened, equities tend to rise. The strong correlation is down to the cyclicality of the index; autos and industrials, which represent a large proportion of the index are export-heavy sectors so naturally have currency sensitivity. A stronger yen could hurt earnings and the overall market.

Abe confirmed that the consumption tax hike will go ahead in October 2019 from the current 8% to 10% to help pay for social security costs arising from the rapidly ageing population.

The hike has been delayed twice citing concerns over the economy. The last time consumption tax was raised from 5 to 8% in 2014. If the hike goes ahead, recession risks are higher.

Consumption is not strong enough to counter slowing demand and negative effects of the hike, given a backdrop of slowing domestic and international demand.

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